Nonfiction review: 'I.O.U.'

My wife the Reedie sometimes jokes about taking poet's math at college: math courses catering to English majors for whom the sight of a quadratic equation might occasion a spell on the nearest fainting couch.

But the sheer size of the worldwide financial implosion and the ongoing bailouts is enough to make most of us feel distinctly mathphobic, and a poet's math-style explanation of the Recent Unpleasantness might not be misplaced.

John Lanchester's excellent "I.O.U.: Why Everyone Owes Everyone and No One Can Pay," is that explanation. It's cogent, deeply researched and deals with people and their motivations, even while discussing such financial arcana as collateralized debt obligations and NINJA mortgages -- No Income, No Job or Assets. And it reads like a fascinating novel, due in no small part to the fact that Lanchester -- author of the subtle and beautiful "The Debt to Pleasure" and others -- is a very good novelist indeed, as well as an accomplished journalist.

"I've been following the financial crisis for more than two years now," Lanchester writes in the introduction. "I began working on the subject as background to a novel, and soon realized that I had stumbled upon the most interesting story I've ever found. ... It is an absolutely amazing story, full of human interest and drama, one whose byways of mathematics, economics and psychology are both central to the story and mysteriously unknown to the general public."

Spoken like the novelist he is, and written that way too: "I.O.U." is the book for people who wonder how the world blithely accepted a doubling of its total wealth from $36 trillion in 2000 to $70 trillion in 2006 without asking when and how the bubble might burst.

Lanchester narrates a tour of Cloudcuckooland, where many financial institutions were apparently headquartered in the past decade. He talks of the credit default swap, CDS, which is a way to lend money to a company and then sell the risk of not getting paid back to a third party for a monthly rate -- an insurance payment, so to speak. Because the money you lent is now not at risk -- if the borrower defaults, the third party makes up the loss -- you're theoretically free to lend out that same money again to someone else and create another CDS.

Well, not you or I, of course, because we're mere people and can't set up synthetic offshore corporations and issue ourselves credit. But financial institutions could and did because they're run by trained professionals, and what could go wrong there?

The same thinking applied to collateralized debt obligations or CDOs, asset-backed securities whose value and payments derive from a pool of fixed-income assets. Assets such as subprime mortgages -- subprime referring here to the borrowers' ability to repay and not their mortgage rates, which were higher, usually, than old-fashioned conservative mortgages. Because home values were certain to rise forever, lenders thought, they could get people into mortgages who would never have qualified before and make money for themselves in the process. And because lenders were laying off any risk to third parties, what could go wrong?

Lanchester even has a credible candidate for the man who brought the world to the brink of ruin, David X. Li, "a math jock from rural China," Lanchester writes in the chapter "Enter the Geniuses."

"In 2000, while working at J.P. Morgan, Li managed to apply a piece of mathematics called a Gaussian copula function to the creation of CDOs ... in plain English, it is a way of modeling lots of different things happening in different ways at the same time ... he had found the Great White Whale of the CDO market, a way to correlate the apparently uncorrelatable, and thus had opened up the whole field of subprime loans as a source of CDOs."

"These new financial instruments were very, very clever," Lanchester writes, "but they had an unfortunate side effect: they broke banking. Banking is at its heart, or should be, a simple business. Customers deposit money in a bank in return for interest; the bank lends that money to other people for a higher rate of interest."

And we have to ask ourselves how much we really need and want. "In a world running out of resources," Lanchester says, " the most important ethical, political and ecological idea can be summed up in one word: 'enough.'"